By Bradley Hope 

Exchanges and market makers are getting a fresh look from portfolio managers seeking out investments likely to benefit from the large swings in stock, bond and currency markets.

Among those deemed likeliest to profit from the market's rising volatility, many investors say, are futures and options exchanges such as CBOE Holdings Inc. and CME Group Inc., and trading firms including Virtu Financial Inc. and KCG Holdings Inc.

The Dow Jones Industrial Average last week posted its largest-ever intraday point decline and its biggest two-day gain, before finishing the week up 1.1%. Many analysts say the conditions that led to the tumult remain in place, reflecting uncertainty over the pace of global economic growth, the timing of likely interest-rate increases and the high valuations of stocks and bonds relative to historical averages.

Accordingly, many investors are seeking to reduce risk, including by using futures, options and other derivatives to hedge against possible market declines. The pickup in activity is likely to bolster results at CME and CBOE, which are the dominant players in some futures and options markets, and at Virtu and KCG, trading firms that may post larger relative gains than more-diversified stock-exchange operators, analysts said.

Last week, shares of Virtu rose 8.6%, KCG advanced 4.9%, CBOE rose 3.9% and CME gained 3.3%.

"The more exposure you have to trading fees, the bigger earnings impact you're going to see," said Alex Kramm, an analyst at UBS Group AG who covers exchanges and discount brokers. He has "buy" ratings on CME, Virtu and Intercontinental Exchange Inc.

The exchanges profit by charging fees on transactions. Investors like this model because it makes the companies more profitable when volume picks up without exposing them to large risks associated with the direction of prices.

Daily U.S. stock trading exceeded 10 billion shares each day from Aug. 24 through Thursday, compared with its average of 6.7 billion a day for the year to date. Total trading volume on the CME exceeded 20 million futures contracts a day, compared with its average of 13.9 million contracts for 2015.

Topping the list of likely beneficiaries for many analysts is CBOE, the Chicago-based owner of the Chicago Board Options Exchange.

The CBOE Volatility Index, or VIX, is the most widely tracked gauge of investor anxiety and often is used by investors to hedge in jittery trading environments. Average daily trading of VIX futures contracts has risen 44% from the second quarter to 263,000 in the third quarter to date, while average daily trading of VIX options has jumped 58% to 815,000.

Thomas Caldwell, a longtime exchange investor and owner of CBOE shares, said CBOE was likely to be one of the largest beneficiaries because of its monopoly on the VIX.

"There's stickiness to the CBOE product that the other exchanges don't necessarily have," he said.

Another likely winner: CME. The world's largest futures exchange operator, has averaged about 16.4 million contracts a day in August, up about 28% compared with July.

CME shares are up 24% and CBOE shares up 20% over the past year, against a 0.7% decline in the S&P 500.

Market-making firms, such as Virtu and KCG, also tend to have higher profits during busy times in the market. Such firms trade more and the spread between bids and offers for securities and derivatives also tends to widen, which means greater profitability on a higher number of trades. They do this by simultaneously offering to buy and sell securities in the market, seeking to make a profit on the difference between the two prices. Most firms do this using automated trading algorithms

Richard Repetto, an analyst at Sandler + O'Neill LP, said last week that he was increasing his estimate for Virtu's third-quarter earnings per share by a dime a share, to 35 cents. On Monday alone, the firm traded four times its normal volume, Mr. Repetto said.

To be sure, there are significant risks for purchasers of any of these shares. CME and CBOE trade at higher valuations than the market, at a time when many analysts consider the market price/earnings multiple to be stretched.

The trailing 12-month P/E for KCG is 5.25, for CME it is 26.8 and for CBOE it is 29.14, while the S&P 500 is 17.1.

KCG trades at a modest valuation, but the firm's history points up another risk, that a technology glitch or other misstep can expose firms to outsize losses. KCG was formed when Knight Capital Group Inc. merged with a large shareholder following a $440 million trading loss.

If the markets are rocky for an extended period, it can reduce other business lines for some firms. Clients may reduce their use of margin, which would reduce profits from margin lending by brokers, said Mr. Kramm of UBS. That could be a risk for another group favored by some analysts, the discount brokers TD Ameritrade Holding Corp., E*Trade Financial Corp., Charles Schwab Corp. and Interactive Brokers Group Inc.

Retail investors may also begin trading less if the markets continue to be roiled by volatility spikes, leaving them with "shell-shock" and likely reducing volume and profits at firms including New York Stock Exchange owner Intercontinental Exchange and Nasdaq OMX Group Inc.

Write to Bradley Hope at bradley.hope@wsj.com

 

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(END) Dow Jones Newswires

August 31, 2015 09:27 ET (13:27 GMT)

Copyright (c) 2015 Dow Jones & Company, Inc.
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